Recap 2015-01-10: Oil & Yields

Because shale can rebound quickly once capital investments return, we now believe WTI needs to trade near $40/bbl for most of 1H15 to keep capital sidelined.

Excess storage and tanker capacity suggests the market can run a surplus for a very long time, preventing storage blowouts and a collapse in cash prices. This leaves cash prices as a simple storage arbitrage to the forwards. As producers hedge 9-12 months out, new capital primarily focuses on the 12-24 month strip, making this the new market anchor that enables the capital markets to balance the future physical markets. To keep capital sidelined, this strip needs to remain well below our revised ‘new normal’ WTI estimate for the marginal cost of production of $65/bbl. Due to significant cost deflation and efficiency gains, we are lowering our estimate for marginal costs to $65/bbl and $70/bbl for WTI and Brent from $80/bbl and $90/bbl, respectively. These are our new ‘normal’ price forecasts. As a result, we forecast that the one-year-ahead WTI swap needs to remain below this $65/bbl marginal cost, near $55/bbl for the next year to sideline capital and keep investment low enough to create a physical rebalancing of the market.

However, supply tends to rises more quickly than it falls in response to investment. As a result, the short-cycle nature of capital investments in shale requires that such pressure remain in place long enough to keep capital sidelined while the market rebalances, creating a more U-shaped type of recovery in prices. The large availability of low-cost external capital from either private equity or international majors exacerbates this need for sustained low prices to keep these assets from quickly being redeployed in a lower cost environment.

Once a 2H15 US supply growth slowdown is more certain and given the very high decline rates on US production, renewed Libyan disruptions and an already visible demand response in the US, we expect the market to rebalance with inventories drawing rapidly from 3Q15 onwards. To accommodate the substantial expected first half inventory build and using the storage arbitrage to the one-year ahead swap, we are revising down our 3-, 6- and 12-month price forecasts for Brent to $42/bbl, $43/bbl and $70/bbl, respectively, from $80/bbl, $85/bbl and $90/bbl, and for WTI to $41/bbl, $39/bbl and $65/bbl from $70/bbl, $75/bbl and $80/bbl. The later expected trough in WTI prices is due to excess US storage capacity.

While history would suggest that a storage blowout would push spot prices below $35/bbl, we believe that by avoiding breaching storage capacity, the market will hover around $40/bbl, potentially dipping at times into the high $30/bbl which we see as the likely lows of this cycle. Importantly, this remains above the price of shut-in and default

Despite being seemingly obvious, the realization that drilling in the ocean is far more expensive than drilling on land is really the key to the recent sell off, particularly for longdated prices. Before July 2014, the market was supported on a longer-term basis near $100/bbl by higher cost deepwater offshore and oil sands projects. As shale production surged in late 2013, it became increasingly clear that the size of the onshore resource base and the prolific nature of these projects made drilling in the sea and mining high cost oil sands a redundant more expensive source of supply. As these project economics became increasingly uneconomic, the market moved from pricing them at the margin to pricing shale at the margin, which created the initial re-pricing of long-dated prices from over $90/bbl to under $80/bbl.

Now, obviously this is just the view of one bank. But this is particularly important for global macro assets because oil prices have increasingly become the principal driver. And in fact, this is not unusual. The last two instances of oil declines that did not occur with a US recession was 1997-1998 and 1985-1986. Let’s take a look at how 30yr yields did then:

1997-1998. Keep in mind events that occurred then: the Asia crisis, LTCM implosion, US budget surplus, which are all supportive of bond prices:

1985-1986:

As I noted in my note about 10y breakevens last week, large moves in oil prices are likely a larger and more temporary driver of yields than many market participants recognize. And it may be another reason why SF Fed president Williams said today that a mid year lift off is still ‘reasonable.’

Notable:

The switch in regulatory oversight from the Bank of Spain to the ECB’s Single Supervisory Mechanism (SSM) played a big role in Santander’s big equity raise last week. Some analysts think Unicredit, BNP, Raiffeisen, BNP, SocGen, DB, and Commerzbank may have to raise additional capital. FT

Fewer Chinese than expected want second child: state media: According to the newspaper’s calculations about 30,000 families in Beijing, just 6.7 percent of those eligible, applied to have a second child. The Beijing government had said last year that it expected an extra 54,200 births annually as a result of the change in rules. In Liuzhou city, in the southern Guangxi region, only 20- percent of eligible families applied, while in Guilin city 30 percent applied. And in Anhui, a largely poor central province, just 12 percent applied, the newspaper said. The newspaper cited a demographic expert as saying that families were worried about the cost of raising a second child. – Reuters

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I am a G20 Global Macro Portfolio Manager in NYC. My background includes stints at a major investment bank, a commodities market maker, and one of the world's largest global macro hedge funds.
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